Part 2: The Bank of England

May 28, 2015 | St. Louis Mo.

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Stephen Williamson, a vice president and economist with the St. Louis Fed, outlined his Dialogue with the Fed discussion "Monetary Policy Normalization: What’s New? What’s Old? How Does It Matter?" He began by discussing the origins of central banking, starting with the Bank of England. Among other things, the Bank of England helped usher in innovations such as being the lender of last resort and being a country’s sole issuer of currency.

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Transcript:

Stephen Williamson: Hey, can you hear me well?

Cletus Coughlin: Yep.

Stephen Williamson: So thanks for coming out. So what I'm going to do is—well, first of all, I have to give my disclaimer. I don't speak for the Federal Reserve System. These are my views I'm telling you about, not necessarily the views of the Fed, or St. Louis Fed. Okay, so what I was going to do is I'm going to take you back a bit in history. So I'm going to frame this, partly in terms of origins of central banking, origins of the Fed, and kind of put this in context. We want to get some idea what a conventional monetary policy is, to understand what's unconventional and what returning to normal would be about. So here's what we're going to do.

Okay, so I'm going to take you back to King Billy, and the Bank of England, origins of the Bank of England. Billy was originally William of Orange. He came from Amsterdam. So Amsterdam, it's important in banking history because it's one of the European centers where banking started. So the 17th century, that's the origins of banking, private banking, and the origins of central banking too. They kind of went together. So William came to England. He kicked James out of England, the king, and took over the English crown. And part of what he did was establish the Bank of England in 1694.

So at the time, it wasn't like the people decided to start up a central bank because economists were telling them to do that. Economics didn't exist at the time. There wasn't a science behind this, or any idea that it was for the public good or something. It was an arrangement between the king, and the Bank of England, which was a private bank. It was a private bank until 1946, in fact. So we're going to have to think about central bank balance sheet here. This is going to be important, so here's a balance sheet. I'm not an accountant. I never took accounting. So I have a hard time remembering what side of the balance sheet to put assets on. But here's assets and liabilities in a primitive central Bank of England.

So basically, the Bank of England was in the business of, one, making loans to the king. So they're funding, you know, it's like a cheap way to fund the government. From the king's point of view, it's a cheap way for him to finance a war. And what did the Bank of England get? The Bank of England, in return, they got a monopoly. And they got the right to issue notes, you know, bank notes. This is currency. So private banks at the time issued currency. The Bank of England is just another private bank, but it's given—it's given kind of a local monopoly at first, in the vicinity of London. And then eventually, they get a monopoly on the whole business. They get a monopoly on currency issue in the U.K. in 1844.

So this is just a nice arrangement for everybody. And essentially, you know, as we understand it now, it's actually a socially beneficial thing too. They didn't—it's not like they thought of it that way, but it was. So the notes in circulation, you know, was a paper currency issued by banks. You know, initially, there's some competition between the Bank of England and these other private banks that are issuing private currencies, essentially. They're in a world where the notes are redeemable in gold, and they're used in transactions, just like currency's used in transactions today. Less all the time, of course. You could always take a note into the bank of issue, and get it redeemed in gold, during the gold standard.

So part of what the Bank of England learned was crisis management. Again, they're not doing this because it's for the public good. They're doing it because they made a profit doing it. So what would happen? So think about it. A crisis being an event where people start to mistrust these banks. I've got other banks up here. Other banks, there are other private banks that are running into trouble for some reason, because the public at large starts thinking these banks is untrustworthy for some reason, and they start withdrawing gold. They take their notes into the bank, and want to withdraw gold. But they start to trust the Bank of England, so the Bank of England becomes kind of a safe haven. Becomes something—this institution they trust, and so what's happening during this crisis is people are depositing gold in exchange for notes, which they find useful. They're useful in transactions. They find notes of the Bank of England useful, and they can transactions. And the Bank of England is sitting there, getting all these deposits. It starts thinking, well what I can do with this gold that's been issued is I can make loans to these other banks. So why does it want to do that?

Well, it's looking at these other banks, and it's thinking, well I maybe know more about this than the general public does. I've got insight—the Bank of England is thinking it's got inside information about which of these other banks are actually viable and which aren't. So it starts picking winners and losers, and lending to the winners, and makes a profit doing it. And that's crisis intervention. It's making loans to the viable banks. And what happens in the crisis is the Bank of England expands. Its balance sheet expands. It's making loans, and it's issuing more liabilities than it's managing—effectively managing the crisis. That's how central bankers learned how to do this, learned crisis management.

So when they do it, you know, one of the early crises—nothing new about financial crises. These have happened for centuries, right? So the one is the South Sea Bubble, which you might know about. And this is like the South Sea Company was like a joint government, private enterprise with nothing to back it up. Eventually, this is not going to pay off, and it took people awhile to figure this out. But in the meantime, banks are failing, and individuals are going bankrupt, et cetera, and the Bank of England is making a killing. So what happens is the—and through the 18th and 19th century, there are various financial panics. Badgett wrote about this. This is a famous book, Badgett's book. People cited—they went back and thought about this in the recent crisis. You see a lot of references to that. This is basically; this is the basis of sort of a modern idea of the central bank as lender of last resort. Sort of where it came from.

Okay, so innovations of the Bank of England, one is this idea that a central bank as a sole issuer of currency. National currency that's in some sense uniform. You know, there's one currency, everybody knows what it is, and it's safe. Because people come to trust the Bank of England. There's a financial crisis intervention that kind of got invented by the Bank of England. But again, it just comes out of this desire to make a profit. In terms of modern economics, we can think about why this kind of central banking arrangement was useful.